Principles of Nonprofit Investment Management - Commonfund

Many such analytical tools are availableto institutional investors to aid themin making asset allocation decisions.Their utility, of course, varies. Thosemodels that use the concept of theefficient frontier must, by definition,assume the predictive validity of historicdata. But it’s axiomatic that pastperformance does not necessarily predictfuture results. Economic andfinancial events often swing far outsideof past ranges, and the ranges are notalways reflected clearly in the averages(e.g., the average temperature of a mansitting on a cake of ice with his feet ina stove).The allocation planning model usedat Commonfund factors in manydifferent economic scenarios to projecta very wide range of possible outcomesfor any given asset allocation. In acomplex statistical process, the modeluses “Monte Carlo simulation” torandomly generate a thousand differentyield curves for next year and thenprojects how each of these is likely toaffect the results of each of nineteenasset classes.For each of the thousand scenarios,the model then generates anotherthousand yield curves for the secondyear and again projects the probableresults for those nineteen asset classes.The model runs these simulations foreach of twenty years into the future.Having processed so many differentpossible values for each variable, themodel’s output will show not just amean outcome but also a distributionof possible outcomes for each projectedinvestment period and the probabilityof each of those outcomes. Thisapproach, as you can see, goes beyondhistorically based averages and looksat what economic and financialconditions might really turn out tobe down the road. It also allows forthe examination of risk in the tailsof potential outcomes beyond onestandard deviation.As a further guide for their decisionmaking, investors are also advised totake a hard look at the present environment,consider what the economic andmarket outlook might be for the nextfew years and what that suggests forinvestment strategy.No matter how sophisticated theplanning tools employed, the futureis unknowable. Ultimately, it comesdown to human judgments aboutwhat could happen, based on the bestinformation available at the time.Sometimes basic questions can tip thebalance. For example, in an environmentof rising interest rates, shouldn’tyou be underweighting your bondallocation? When the returns of thebroad indexes are expected to becomparatively modest, shouldn’t yoube giving greater emphasis to skillfulstock picking and opportunistic tacticsto help achieve the returns needed tocover payout and inflation rates?- 18 -